Rise of the Machines: How Technology Can Lower Your Corporate IQ

(MoneyWatch)  Tufts University business professor Amar Bhidé has a radical proposal for how bankers and government regulators can make the U.S. financial system safer and more effective: Think. Writing in the Harvard Business Review, he lays much of the blame for the housing crash on the substitution of statistical models, formulas and algorithms for human judgment:

These mechanistic decision-making technologies have value under certain circumstances, but when misused or overused they can be every bit as dysfunctional as a Muscovite politburo. Consider what has just happened in the financial sector: A host of lending officers used to make boots-on-the-ground, case-by-case examinations of borrowers' creditworthiness. Unfortunately, those individuals were replaced by a small number of very similar statistical models created by financial wizards and disseminated by Wall Street firms, rating agencies and government-sponsored mortgage lenders.

This centralization and robotization of credit flourished as banks were freed from many regulatory limits on their activities and regulators embraced top-down, mechanistic capital requirements. The result was an epic financial crisis and the near-collapse of the global economy. Finance suffered from a judgment deficit, and all of us are paying the price.

As technology pervades (invades?) the workplace, that critique raises a key question that applies not only to financial pros, but to most business managers. Namely, when should you rely on a computer to make a decision, and when should you let less tangible measures -- such as instinct, customer relationships, professional experience and street smarts -- be your guide?

Fine, so the conclusions produced by such calculating devices often aren't easily reducible to 0's and 1's. But that's a good thing. Because that PC on your desk is shifting the balance between personal judgment and the kind of rigid, simplified rules that powers much automation, Bhidé says.

Take how derivatives were designed and sold. As with mortgages, contracts such as credit default swaps and collateralized debt obligations are priced based in part on estimates derived from historical data. The only problem with that is that these estimates are often wrong. They frequently misrepresent risk. That's because risk -- that, say, housing prices could plunge 30 percent or a giant insurance company might fail to take even basic precautions against collapsing in a heap -- is hard to quantify. The models used to value swaps aren't sleek, minimally-invasive tools for financial innovation so much as blunt instruments, failing to factor what Bhidé calls "situation-specific" info. He writes:

Such highly abstracted, top-down conceptions of risk -- the "delta" of a derivatives book or the "beta" of a stock portfolio -- allow the CEOs of financial behemoths, at least in principle, to manage a wide range of activities with little knowledge of the details of any one. Regulators, who once focused on loan-by-loan examination of banks, have also embraced the top-down approach to risk control. The scrutiny of individual risks has been abandoned.

For banks, subsuming human judgment to black boxes is especially problematic in the age of modern finance because markets are more complex and fast-moving than ever. When the future no longer much resembles the past, it's tough to devise good rules for the present.

Bhidé has a simple solution for such problems. And it's not for financial firms to refine their equations or regulators to lock down the prison-yard. Rather, he proposes reinstating an "old-fashioned" approach to banking "in which bankers know their borrowers." Anticipating the inevitable arguments that it's too late, as globalization spreads, to put the financial genie back in the bottle, Bhidé advocates limiting what government-backed banks can do while liberating other financial players to follow their bliss:

This could be accomplished by tightly limiting what banks can do: Specifically, they should do nothing besides make loans to individuals and nonfinancial businesses -- after conducting boots-on-the-ground due diligence--and conduct simple hedging transactions. The standard for making a loan or hedge would simply be whether it could be monitored by bankers and examiners who don't have PhDs in finance, and whether the risk is one that bankers would take if it were their own money -- a "prudent lender" rule, in other words.

These rules would apply to any entity taking short-term deposits from the public, whether or not it was called a bank. All others -- investment banks, hedge funds, trusts, and the like -- could innovate and speculate to the utmost, free of additional oversight. But they would not be allowed to trade with or secure credit from regulated banks, except perhaps through loans collateralized by liquid, high-quality securities. No lending against or purchasing of collateralized debt obligations, and no financing of warehouses of loans awaiting securitization, for instance.

Good thinking.

Image from Flickr user popculturegeek.com
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